By Steven M. Sears
He who changes his volatility first wins.
This options-market trading proverb is a pithy reminder of the importance of having a view on implied volatility, arguably the key determinant of put and call values.
A smart trader wouldn't sell bullish calls with low implied volatility on hot stocks about to report earnings. If stock and call values surged after a good report, it would force the trader to pay out way more than expected or miss out on gains.
The volatility proverb reflects the collective experience of floor traders who found themselves on the wrong side of trades. When options traded in open-outcry pits on exchange floors, rampant insider information about earnings and mergers -- which gave those in the know an unfair advantage -- was a constant threat.
If dealers and market makers raised implied volatility ahead of earnings, the probability of a surprisingly good earnings report taking out a floor trader was small. The heightened volatility level provided a margin of safety. In recent years, by contrast, many investors have been able to ignore volatility and trade options profitably by betting on stock momentum.
The start of fourth-quarter earnings season, a key determinant of options volatility and stock prices, will create something of a quandary for investors. They will need to balance their enthusiasm for President-elect Donald Trump's policies against earnings and outlooks.
Corporative executives will likely be maximally glib on earnings calls. They won't want to mislead investors, but dour outlooks likely won't curry favor with the Trump administration. And there are inescapable realities, too: Some companies will preannounce earnings, making options trading more difficult.
John Marshall, Goldman Sachs' derivatives strategist, recently reminded clients that January is a busy month for earnings shortfall news. Since 2011, he noted, about 26% of more than 8,000 preannouncements occurred in January. Healthcare and consumer-discretionary stocks accounted for more than 60% of them.
Marshall found 25 companies with market capitalizations over $1 billion that have preannounced at least five times over that period. Lululemon Athletica, Illumina, Five Below, American Eagle Outfitters, Intuitive Surgical, Regeneron Pharmaceuticals, and Danaher top his list.
He has long favored covering such stocks with at-the-money straddles that expire in three months. The strategy, which entails buying a put and call that match the stock price, is used when investors think a stock will sharply swing up or down in reaction to news.
For most investors, the greater value in this month's preannouncements and earnings reports may be in what they say about the market. Watch how stocks react, and contrast that and what executives say against Wall Street's expectations.
We remain convinced Trump is good for stocks, but a gap exists -- it always does -- between investment sentiment and hard facts, like earnings and government policies. Use short-term events -- like earnings news -- to reconfirm your investment theses. Trump's inauguration and earnings will help reset or reaffirm volatility levels.
Oppenheimer's Michael Schwartz, the dean of Wall Street's options strategists, says this moment reminds him of the earliest days of options trading, before the listed market was created in 1973. Back then, cloudy market moments were handled by letting market forces determine prices, rather than by investors trying to force their own views.
"The market knows what stock and options are worth even when you don't," he says.
That fact should chill the many investors who think they are momentum-trading wizards who can outsmart the market.
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January 08, 2025 01:30 ET (06:30 GMT)
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